Monday, December 15, 2008

Recession without Boom?

Usually, recessions follow a boom - a period of rising inflation and unsustainable growth. For example, you can see significant recession in 1974 after the Barber boom. The last recession 1991, came after the prolonged Lawson boom of the late 1980s.

Yet, this recession came despite any obvious period of unsustainable growth and high inflation. Growth was rarely above the long run trend rate and inflation was more or less on target, (apart from a rather misleading temporary cost push inflation from rising oil prices.)

Yet, although on the surface, the economy was a paragon of stability, if we dig deeper we can see an element of boom and bust.

Boom and Bust in Housing Market.

House prices tripled during the decade 1996-2007. House prices are now falling sharply. The impact of the housing market on the economy should not be understated. Rising prices encourage a fall in the savings ratio; people remortgage and are more willing to spend on credit.Falling house prices cause a collapse in confidence and willingness to spend.

Current account deficit

The UK saw a rise in the current account deficit. This is indicative of suppressed inflationary pressure. As the domestic economy achieves shortages, people respond by buying imports. A rising current account deficit implies a greater % of GDP is devoted to consumption. The economy is consuming more than it is producing.

Boom and Bust in Credit.

Tied closely to the state of the housing market is the availability of finance. Rising house prices give banks incentives to make credit freely available. Falling house prices cause a retrenchment as lenders protect themselves against negative equity. This natural credit cycle was exacerbated by a rise in new types of bank lending. In particular, banks were more willing to borrow on short term credit markets in order to lend mortgages. With the case of Northern Rock over 70% of their mortgage lending was financed through short term lending on money markets. When credit markets suffered the credit crunch - they were stuck.

Recession Without Boom

One of the lessons from this current recession is the need to regulate different aspects of the economy and finance markets. In other words it isn't sufficient just to target inflation. Economic growth can become unbalanced - even if growth and inflation look good.

Of course, some countries really are experiencing recession without having a boom. Germany and Japan are both in recession, but their economies displayed little or no sign of boom before the bust. It also shows that we are facing a global downturn which is affecting all major economies.

Source of data: Speech by Andrew Sentance, Bank of England - THE CURRENT DOWNTURN – A BUST WITHOUT A BOOM? Tuesday 9th December 2008